Monday, January 16, 2012

Time to stop fearing the Greek CDS bogeyman

A Wall Street Journal article today described a process that could potentially accelerate the Greek debt restructuring. The delay in negotiations between the bond holders and Greece is a complete distraction for the eurozone leadership. They need to be focused on putting together the new eurozone treaty, instead of worrying about Greece going into a "disorderly default" as the €14 billion of debt nears maturity. The idea described in the Journal talks about a collective-action clause that could be incorporated into the bonds to kick start the restructuring process.

WSJ: One intriguing idea knocking around European political and financial circles is a four-step plan that begins with Athens inserting collective-action clauses into the existing stock of domestically issued Greek debt (some 93% of the total). Under a collective-action clause, a group of bondholders (typically two-thirds or three-quarters) can agree to impose losses on everyone else.

However this process, driven by a majority vote, is no longer "voluntary" and is expected to trigger a "credit event" under ISDA - the feared "CDS trigger". The ECB is spooked by the idea.

WSJ: The obvious objection to this idea is that it would inevitably trigger a "credit event" under the terms of Greek credit-default swaps (CDS). The ECB in particular has insisted that CDS contracts not be triggered, which is why the focus has always been on a purely voluntary bond exchange.

Apparently the reason for ECB's unwillingness to allow Greek CDS trigger stems from their belief that it will hurt some EU banks who have written protection on Greek debt. But this persistent view that the banking system will be devastated by Greek CDS triggering is nothing but a myth. Here is why:

1. People still think that CDS is an insurance contract. And when a hurricane hits, the insurance industry gets hurt. That is not true with CDS. Unlike bonds held in banking books or loans, derivatives contract get marked to markets daily. All the banks have to do is look at their Bloomberg monitors and mark the contracts - it's a transparent market (in spite of what many believe). The losses associated with Greek CDS have already been taken by banks who wrote this protection - a while back.

2. There has been relatively little trading in Greek sovereign CDS. In fact it didn't even make the top 30 "single name" CDS on the list disclosed by DTCC, a service used to settle CDS trades (it is number 35, after Telefonica SA on a net basis - hat tip Guest). That means the bulk of the protection written was some time ago and there is little "systemic" risk from any new contracts.

3. Even with the unexpected delay in negotiations, the CDS is slightly "tighter" (premiums are lower) now than a month ago. That means that the worst case scenario has already been priced into the market. The chart below compares Greek CDS curve now with the curve from December 16th (note that the curve is inverted because the credit is distressed.)

Greek CDS spread curve change from a month ago (Bloomberg)

4. The 5-year Greek CDS currently trades at 70 "points upfront" (distressed credits typically trade this way). What this means is if you buy protection on €100 bond, you have to pay €70 in premium upfront. If the bond ends up being worth zero, the most you can make is €30. The CDS market has therefore already priced in a 70% haircut. The bond holders will exchange €100 of the old bonds for €50 of the new bonds and the new bonds are expected to trade at 60 cents on a euro (0.6 x 0.5 = 0.3).

Depending on the outcome of the auction process involved in settling "triggered" CDS, it is possible that banks actually end up recovering some of the losses they've already taken. The chart below shows the "points upfront" (deep haircuts) curve for Greek CDS - which is a better way of looking at this market.

Current Greek CDS points upfront for various tenor contracts

If it helps to push through the Greek restructuring faster via a process involving triggering CDS, it needs to be done. The banking system will be just fine - it has bigger problems unrelated to Greece. In fact the sooner the eurozone can put the Greek restructuring mess behind them, the better it is for the banking system and the eurozone as a whole. It's time to stop treating the Greek CDS market as the next hurricane - the hurricane has already passed. Instead the eurozone should work on avoiding the next one.